Bank Goodwill and Bond Market Liquidity

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
Read More.

I have written before that the accounting value of a bank is a nebulous thing. "A bank is a collection of contracts that provide for future cash flows," I said, "and the value of those contracts depends on your guesses about the future cash flows." Still we mostly muddle along; a lot of those contracts are like Treasury bonds and stuff, and you can kind of figure out what they're worth. Meanwhile a lot of the actual value of a bank comes not from its existing contracts but from its ability to make more money in the future, by winning merger mandates or earning trading commissions or whatever. Guesses about these future earnings are extremely important to how investors analyze the value of the bank, but generically speaking they don't inform the accounting value. The accounting is just based on the contracts you actually have. But there is a big exception: If you acquire a company, and you pay more for that company than the book value of its tangible assets, then presumably you are paying for the expected future earnings that are not bound up in those tangible assets. You're paying for the company's ability to make money in the future. And you have to account for that payment, and the way you do that is by attributing accounting value to that future ability to make money, which is called "goodwill."

Yesterday Deutsche Bank announced that it "expects to incur charges that will materially impact third quarter 2015 results." There are several items here, including litigation provisions, but the big one is this:

An impairment of all goodwill and certain intangibles in Corporate Banking & Securities (CB&S) and Private & Business Clients (PBC) of approximately EUR 5.8 billion. This is largely driven by the impact of expected higher regulatory capital requirements on the measurement of the value of these segments as well as current expectations regarding the disposal of Postbank.

For Deutsche Bank, constraints on earnings coupled with regulators’ demands that the bank set aside more capital mean that its investment bank—notably including the Bankers Trust business it bought in 1999—isn’t expected to generate the profits it had in the past.

"New chief executives often take 'kitchen sink' financial charges to clean up problems or complete unfinished tasks left by the former leaders," points out Peter Eavis, "and this may be what’s happening at Deutsche." The stock was down on the news, though that may have more to do with the fact that Deutsche may eliminate its dividend for the year as part of its "Strategy 2020" to become a stronger and safer bank. The goodwill write-down, after all, is in some sense a non-event. It "will have no significant impact on Deutsche Bank's regulatory capital ratios," Deutsche says, which makes sense: Regulators don't allow banks to count expectations of future profits (i.e., loosely, goodwill) as part of their equity for capital purposes, so reducing those expectations won't hurt capital. And as Paul Davies notes: "For some time, Deutsche Bank investors have cast doubt on the firm’s intrinsic value—the stock hasn’t traded at or above book value in years," so the market has long since reduced its own expectations about Deutsche's future profits. Now Deutsche is just catching up.

Fraud.

The Wall Street Journal has more on the bizarre story of Iftikar Ahmed, who "fled the U.S. in May" after allegedly stealing $65 million from Oak Investment Partners, the venture capital firm where he was a partner. We talked about his SEC case a while back, but the story gets even weirder. For instance, one of the charges against Ahmed is that he got Oak to pay $20 million for a company, got the company to accept $2 million, and pocketed the difference:

Oak executives later testified that they didn’t learn of the actual $2 million sale price until after Mr. Ahmed’s arrest, even though the seller disclosed it in a news release, according to court filings and people familiar with the matter. Oak executives said they also found Mr. Ahmed had massaged financial projections for the Hong Kong company, adding a “1” in front of the revenue figure, to make its sales appear far healthier than they were, according to court documents.

That is ... not very sophisticated? "There is a basis of trust that’s required within the partnership," Oak's chief operating officer said, and I sometimes think that the high levels of finance often operate in surprisingly casual and informal and relationship-based ways. Ahmed, a Harvard Business School and Goldman alumnus and a partner at a big venture firm, apparently fit well into that relationship-based system, and had a lot of trust to exploit if he wanted to.

On Monday, the New York Times reported "what amounted to allegations of insider trading" in daily fantasy sports, in which an employee of fantasy site DraftKings got some early data about DraftKings lineups the same week that he won a lot of money on rival fantasy site FanDuel. By Tuesday, it turned out that there was no insider trading (or whatever): He "received the data at a time when it was no longer possible to change his FanDuel lineup to his advantage." But that brief window in which there might have been something that might be possible to analogize to insider trading was enough for New York Attorney General Eric Schneiderman, who loves analogizing things to insider trading. (You may recall "Insider Trading 2.0," in which he analogized co-location of trading computers and direct data feeds to insider trading; obviously the stock exchanges continue to offer co-location and direct data feeds.) He is now conducting an inquiry into DraftKings and FanDuel, and "is looking at specific allegations that employees of both firms may have made money using company data not available to the public." Go get 'em!

Twitter.

We talked a bit yesterday about Moments, Twitter's new plan to become Snapchat, which is bad. But here is a fascinating story about how Goldman Sachs is considering not releasing its earnings next week on Business Wire. Instead, "it is planning to do so with a release on its own website and a tweet linking to the release." Which seems exactly right. Goldman has a web page: Why publish stuff on a news wire when it can publish the stuff on its own web page, where it can control the layout and put it in the right context and avoid hackers and so forth? But it needs to distribute that stuff somehow, to alert people that the stuff is now on the web page. And Twitter has become the natural way to alert people to content that exists on other web pages. It's a perfect, natural use of Twitter.

It seems to me that if you look at what Twitter actually does, it has become dominant and essential as a way for people and institutions to broadly distribute content that lives elsewhere. (It is also excellent at letting people interact with the distributors of that content.) It has not become dominant or essential or even good at, like, little visual stories about sports events.

The natural intuition here seems to me to be: Make money off the incredible value that Twitter provides to people and institutions who want to broadly distribute their content. Like: Business Wire charges Goldman to distribute its press releases! Why shouldn't Twitter? I think this Matt Yglesias post from June about "How to save Twitter" is along the right lines -- forget advertising, but charge a fee to people and brands who want to reach a broad audience -- though I think the details are hard to get right.

But the unimaginative, user-growth-driven, walled-garden, all-content-must-live-on-our-service approach that Twitter is taking -- in apparent emulation of Facebook -- seems exactly wrong. (Here is some grim brilliant content from John Herrman on that topic.) Facebook is way better at being Facebook than Twitter is, but it is bad at being Twitter. And Twitter is good! Goldman Sachs isn't releasing its earnings on Facebook. Twitter has built a good popular dominant product but for some reason seems to want to get rid of it.

Buy gold!

I love this story about how, after people started doubting the Bundesbank's gold holdings, the Bundesbank released a 2,302-page PDF "listing the location, inventory number, weight and fineness of everysinglebar." The abstraction of modern finance has become so complete that a list counts as proof of physical existence. How could you doubt the existence of something that has been written down on a list? You see this sometimes -- when Jefferies was embattled over European sovereign debt positions in 2011, it released a list of those positions -- and I guess the point is that modern financial institutions exist at a level of abstraction well above that of the list. A bank is at bottom a list of positions, but you cannot describe the bank that way; you need to summarize the positions, and then summarize the summaries, and then do that a few more times, before you can grasp what the bank is. Just publishing the list in an emergency feels so reassuringly concrete, even though the bank isn't really the list of positions, it's the actual positions. Which in the case of European sovereign debt are themselves abstract, though in the Bundesbank's case it's just blocks of gold in a room somewhere.

Obviously in the olden days there were other, more concrete ways of testing that gold was real, and I fell into a bit of an Internet rabbithole about the somewhat counterintuitive use of the bite test for evaluating gold.

People are worried about bond market liquidity.

The latest installment in the New York Fed's series on bond market liquidity is on "Redemption Risk of Bond Mutual Funds and Dealer Positioning," which is the real heartland of bond market liquidity worrying. If you are worried about bond market liquidity as a systemic risk, it is because you think that mutual-fund redemptions will force funds to dump bonds and that, without bank dealers to step in and buy the bonds, prices will plummet and a vicious cycle will ensue.

The New York Fed starts by noting that mutual funds now own more than 20 percent of corporate bonds, up from 4 percent in 1990 and up substantially since the crisis:

This development suggests that the channels of credit intermediation have changed since the financial crisis. Before the crisis, shadow credit intermediation was widespread, involving maturity transformation by money market funds that funded credit. After the crisis, money market fund investments in credit vehicles such as asset-backed commercial paper conduits shrank sharply. Today, money market funds invest in government securities to a larger extent, and market-based credit intermediation has shifted to mutual funds. While credit intermediation by mutual funds still involves some maturity transformation and is therefore labeled shadow credit intermediation, mutual fund maturity transformation is far smaller than the maturity transformation of lengthy shadow credit intermediation chains, which were common before the crisis.

Mutual fund intermediation involves maturity transformation to the extent that you think of mutual fund shares as a demand investment, which they pretty much are, though of course there is good reason not to think of them that way. (They are certainly less "money-like" than money-market fund shares.) The New York Fed goes on to point out that "redemption risk in bond mutual funds does not appear to have increased": The volatility of fund flows "does not seem to be increasing over time." On the other hand:

Even though redemption risk seems not to have increased, the price riskiness of corporate bonds could have increased owing to self-reinforcing dynamics: when adverse news generates lower returns, redemptions might force mutual funds to sell assets, which might reinforce the negative returns, thus generating additional redemptions. The fact that negative returns tend to be followed by net bond fund redemptions can be seen in the next chart. Conversely, positive returns tend to be followed by net bond fund purchases. This gives rise to a positive flow-performance relationship.

And:

For bond funds, Goldstein, Jiang, and Ng 2015 find a concave relationship, so that flows react more strongly to returns when returns are low. The concavity is more pronounced for illiquid bonds, and is stronger when market returns are negative. Moreover, the flow-performance relationship for bond funds is both statistically and economically larger than that for equity funds. These results suggest that the illiquidity of corporate bonds may generate incentives to sell quickly in response to bad news, which might amplify adverse price changes. These incentives might also give rise to self-reinforcing redemption dynamics as investors might anticipate that it pays to redeem early.

So you should worry about bond market liquidity! On the other hand, dealers buying bonds from mutual funds that are selling them is not the solution and never has been. The New York Fed regresses mutual fund bond positions with dealer bond positions and finds a positive correlation:

Dealer positioning tends to evolve in the same direction as bond mutual fund flows, suggesting that dealers aren’t absorbing the aggregate selling pressure of bond mutual funds. In unreported regressions, we do not find any evidence of nonlinearity in the relationship between dealer positioning and bond mutual fund flows. Hence we conclude that the falling ownership share of dealers in the corporate bond market is unlikely to exacerbate redemption risk.

This is intuitive: Bank bond dealers are in the business of moving bonds from one investor to another, not of buying up bonds when mutual funds are dumping them. That would always have been a risky business, never mind what the Volcker Rule says.

Elsewhere here is a really good Institutional Investor article on the modern corporate bond market, which among other things provides some support for the New York Fed's view on dealers. Here is "high-yield-bond guru Martin Fridson":

"People imagine that these corporate-bond dealers have an obligation to stabilize the market," Fridson explains. "That's never been the case in fixed income. There is a mistaken notion that in some past era dealers lost money to prevent the market from going under."

Yep! Read the whole article, though, which is mostly about how buy-side institutions are evolving to deal with declining intermediation by dealers.

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
Read more